ECO Chapters: 13, 14, 15

Dual mandate

- Ensuring price stability - Maintaining full employment

The Fed classifies different types of money by their liquidity

- Hard money - M1 - M2

There are several ways that financial institutions help fill the three basic roles of financial markets:

- Match buyers and sellers - Provide liquidity - Diversify risk

The role of financial markets

- People with spare funds don't always have the most valuable way to spend them. - Financial markets allow funding to flow to the places where it is most highly valued. - A well-functioning market matches buyers and sellers, who can both gain from trade. -- Buyers want to spend funds on something valuable now. -- Sellers let others borrow funds for a price.

At the fundamental level, financial markets start with a bank, savers, and borrowers

- Savers earn more now than they need to spend. - Borrowers need to spend more now than they earn.

There are two basic factors driving differences in interest rates:

- The loan term and - The riskiness of the transaction

The determinants of the supply of loanable funds are:

-Culture. -Social welfare policies. -Wealth. -Current economic conditions. -Expectations about future economic conditions.

The riskiness of the transaction

A default occurs when a borrower fails to pay back a loan according to the loan terms

Speculators

A speculator is anyone who buys and sells financial assets purely for financial gain. Speculators play a unique and controversial role in the financial system. Although all other key players are also out for financial gain, speculators are neither a natural buyer nor a seller, but willing to play either role in an effort to make a profit. There is debate over whether speculators are good for the health of financial markets.

Commodity-backed money

Any form of money that can be legally exchanged into a fixed amount of an underlying commodity is The most common underlying commodity is gold

Savings is upward sloping

Suppliers are willing to provide additional funds at higher interest rates

net capital flow

The difference between capital inflows and capital outflows Capital outflow is when money saved domestically is invested in another country. Capital inflow is when savings from another country finance domestic investment. Note that in open economies, national savings can be more or less than investment. But for the global economy as a whole, savings always equals investment.

core inflation

excludes goods with historically volatile price changes omits commodities like food and gasoline, because the prices of these goods tend to rise and fall more than the prices of other goods.

Derivatives

financial assets that are based on the value of some other asset. Examples of derivatives include contracts based on the future value of mortgages, stocks, or the price of oil. For example, imaging that you are a farmer who sells part or all of your farm crops in advance at a set price. If the crops end up being worth more than the contract price, the buyer can sell them for a profit. However, if the price falls, the buyer loses out, but you still get the contract price.

Federal Reserve System

has a seven-member Board of Governors and twelve regional banks that collectively act as the central bank of the U.S

M2

includes M1(cash plus checking account balances) plus savings accounts and other financial instruments.

headline inflation

includes all of the goods that the average consumer buys

M1

includes cash plus checking account balances

Liquidity

is a measure of how easily an asset can be converted quickly to cash An asset must be converted into cash both quickly and without much loss in asset value. For example, consider a car purchase versus a house purchase. A car is easier to sell, as you can take it to dealer who will give you a cash offer. A house is much harder to sell—it takes longer, you can't expect cash on the spot, and you must find a buyer through an agent.

The net present value (NPV)

is a measure of the current value of a stream of expected future cash flows

deflation

is an overall fall in prices in the economy

Inflation

is an overall rise in prices in the economy

Excess Reserves

is any additional amount that a bank chooses to keep beyond the required reserves

loan

is issued when a lender provides funds to a borrower in exchange for future repayment of the amount loaned plus interest. Loans are generally less risky and less rewarding than buying a stock. This is the most basic and familiar type of debt. Banks issue loans to individuals for purchases of things like houses and cars, and banks issue loans to companies for investment. Loans are less risky than stocks because if the borrower defaults, the lender has the first claim on remaining assets before stockholders. But they are less rewarding because the lender will never receive more than the amount specified in the original agreement, no matter how well the borrower does (as opposed to stockholders, who can earn much more if the company does well).

Reserve requirement

is the amount of money banks must hold in reserve

Required Reserves

is the amount that a bank is legally required to keep on hand

Federal funds rate

is the interest rate at which banks lend reserves to one another. The Fed affects the federal funds rate through changes in the supply of reserves by conducting contractionary and expansionary monetary policy

discount rate

is the interest rate charged by the Fed for loans through the discount window

discount window

is the lending facility that allows banks to borrow reserves from the Fed

Reserve Ratio

is the ratio of the total amount of demand deposits at the bank to the amount kept as cash reserves

open economy

is when an economy interacts with other countries' economies. When money moves across borders, there can be a capital outflow or capital inflow.

Expansionary monetary policy

is when money supply is increased to raise aggregate demand.

Diversification

is when risks are shared across many different assets or people Diversification reduces the impact of a particular risk on any one individual. For example, banks reduce risks because you do not loan to one particular individual. The bank pools your money with that of other savers before making loans to borrowers. If one borrower defaults, no one loses everything (not you nor the bank).

Medium of exchange

money can be used to purchase goods and services. In a barter system, there is no money. You can only trade with other goods. Bartering is inefficient because you have to find someone who both has what you want and wants what you have. Money makes trading easier because you only need to find someone who wants what you have. You sell them the good, take the money, and then buy what you want from someone else. There is no need to find someone who both has what you want and wants what you have.

Unit of account

money provides a standard unit of comparison. Without money, it is hard to compare different offers. Imagine you're trying to sell something, and you receive two offers: 12 crates of eggs or a fine pair of leather shoes. Which is the better option? Money helps us easily compare offers.

Investment

spending on productive inputs. Productive inputs include factories, machinery, and inventories. The demand for loanable funds comes from investment.

efficient-market hypothesis

states that market prices always incorporate all available information, and therefore represent stock value as correctly as possible. This idea underlies the dartboard approach. Fundamental and technical analysis only work if the current price differs from the "correct" price.

Barter

system is where people directly offer a good or service for another good or service.

Money supply

the amount of money available in the economy. The money supply is managed by the Fed

Public savings

the difference between government tax revenue and government spending is equal to T - G

risk premium

the difference between the risk-free rate and the interest rate an investor must pay Credit risk is measured against the risk-free rate is also called credit spread. It can be quite large, both between investors and over time. For example, during the 2007 financial crisis borrowers of all kinds became more likely to default.

Loanable funds

the dollars that are available between lenders and borrowers.

neutrality of money

the idea that real outcomes in the economy are not affected by aggregate price levels. In the long run, the aggregate price level doesn't change real output. Changes in prices don't change purchasing power if all prices change by the same amount. For example, water used to cost $1, but now it costs $100. This does not affect your purchasing power as long as your wage is now $900 instead of $9. Changes in the price level change only nominal values, not real values. The neutrality of money holds in most cases, but not in extreme situations (such as the hyperinflation in Argentina). Extreme and sustained inflation causes frictions in the economy, leading to slower growth.

Central bank

the institution responsible for managing the nation's money supply and coordinating the banking system. In the U.S., the central bank is the Federal Reserve, which has been mandated by Congress to conduct monetary policy to perform two essential functions: 1) Manage the money supply. 2) Act as a lender of last resort.

risk-free rate

the interest rate that would prevail if there were no risk of default is usually approximated by the interest rate used on U.S. government debt, because the U.S. government is very unlikely to default. Other investors pay higher rates because there is a higher possibility that they will default

Savings

the portion of income that is not immediately spent on consumption of goods and services. The supply of loanable funds comes from savings.

interest rate

the price of borrowing money for a specific period of time It is expressed as a percentage per dollar borrowed per unit of time.

A well-functioning financial system would not exist without four key players:

1) Banks and other financial intermediaries 2) Savers and their proxies 3) Entrepreneurs and businesses 4) Speculators

There are three basic approaches used to pick stocks that are most likely to increase in value:

1) Fundamental analysis: Estimate how much money a company will earn in the future. ---includes doing extensive research on an individual company to predict future company profits. 2) Technical analysis: Analyze movements in a stock's prices to predict future movements. ----is often performed with the help of sophisticated computer software. It looks at patterns on the data to predict future movements. 3) Throw a dart: Make a list of all stocks, pin it to a wall, and throw a dart at it. ---might seem like a crazy idea, but research suggests that this approach is often just as good as the first two.

Money serves three main functions:

1) Store of value 2) Medium of exchange 3) Unit of account

Money multiplier formula

1/Reserve ratio

Federal Open Market Committee, or FOMC

Carries full responsibility for setting the overall direction of monetary policy and guiding the money supply

Investment is downward sloping

Demanders are willing to borrow less at higher interest rates

Stability of value

Early versions of money generally took the form of a physical material that was durable and had intrinsic value. Money does not need intrinsic value to maintain stability.

Maintaining full employment

Enacting monetary policy that keeps the economy strong and stable

Ensuring price stability

Enacting monetary policy that meets the needs of the economy while keeping prices constant over time

The equilibrium is where savings intersects investment. Establishes:

Equilibrium interest rate. Amount of money traded in the market.

savings-investment identity

Income = Consumption + Savings ---People can only do two things with their income: spend it now or save it for later. Individuals earn money when people buy goods and service from them: Consumption + Investment = Income ---People can only earn income when people purchase goods or services from them. ---These purchases can be categorized as spending on either consumption (such as meals and clothes) or investment goods (such as factories and machines). Combining the above equations yields: Savings = Investment

Determinants of investment

Investment decisions are based on the trade-off between the potential profits and the costs of borrowing.

Fiat Money

Money created by rule, without any commodity backing it, is U.S. currency is backed only by the trust that the government will keep the value of money relatively constant.

Store of Value

Money represents a certain amount of purchasing power. Money stores value in the sense that if $100 is saved, it is expected that in the future one will be able to purchase approximately $100 worth of goods. However, changes in prices change the value of money (which will be discussed later). Other items (like stocks and land) can also store value. But money can be also used as a medium of exchange.

Savers and their proxies

Mutual Fund and Pension fund Many savers don't approach financial markets directly, but instead operate through a proxy. They give money to someone who decides who to lend it to. In 2001, U.S. households had over $5 trillion saved with mutual funds. There are two main types of pension funds: defined-benefit (which guarantee a fixed payout) and defined-contribution (which pay out depending on how the market performs). A common example of a defined-contribution pension fund is a 401(k).

Fractional-reserve banking

Paper money made it possible for banks to create money through a process called

Convenience

Technology has allowed for the development of more convenient forms of money. For example, paper money is more convenient than gold coins.

Monetary policy Advantages

The Fed does not have to wait for politicians to come to a policy consensus. The Fed is made up of prominent economic policy-makers. It is their job to make sure they fully understand the nuances of the overall economy.

Monetary policy Challenges

The Fed faces time lags and imperfect information. A few months can pass before the Fed's actions make their impact. Mistiming of monetary policy could make economic conditions worse.

The most common example of a derivative is a futures contract

The buyer of a futures contract agrees to pay the seller based on the future price of some asset. Futures contracts allow sellers to transfer risks relating to future prices to the contract partner.

Hard money

The monetary base includes cash and bank reserves, sometime referred to as

The loan term

The opportunity cost of lending money is how long the borrower has to repay the term.

The price of loanable funds

The quantity of savings that people are willing to supply depends on the price they receive. The quantity of investment funding that people demand depends on the price they must pay.

credit risk

The risk of a borrower defaulting on a loan is referred to as

Banks and other financial intermediaries

There are two main categories: Commercial banks and investment banks. Commercial banks accept deposits and lend out money. Investment banks do not accept deposits and do not make typical loans. Instead, they assist companies in issuing stocks and bonds by acting as market makers. Think Wall Street.

stock

a financial asset that represents partial ownership of a company. Stockholders are entitled to receive a portion of a company's profits. Stockholders own the stocks and are the partial owners of the company; they are usually entitled to vote on certain aspects of how the company is run (e.g., electing the board of directors). Companies issue stocks to raise capital without borrowing. Stocks also turn an illiquid asset (i.e., ownership of a company) into a liquid one (i.e., a share that can be sold on the stock market).

Entrepreneurs and businesses

They are often looking to borrow money to finance their latest ventures. Without these borrowers, much of the financial system would not exist. These are the people who engage in economic investment, often with the advice of specialized investment banks that channel savers' money to them.

Demand deposits

are funds held in bank accounts that can be withdrawn by depositors at any time, without advance notice

open-market operations

are sales or purchases of government bonds by the Fed to or from banks on the open market

Bond

a form of debt where the bond issuer promises to repay the loan plus scheduled interest payments. The interest payments on bonds are called coupons. This is a more liquid (and also more tradable) form of debt. They allow companies to borrow large sums of money. Because of the set interest rate, bonds are often referred to as fixed-income securities. Coupon payments are often made every 3 or 6 months. Coupon bonds are typically long-term bonds; short-term bonds (discount bonds) typically don't have coupon payments.

financial market

a market in which people trade future claims on funds or goods These "claims" can take many different forms. - When you get a loan, the bank gives you money now in return for repayment in the future. - Buying a company stock today gives you a right to a share of profits in the future. - When you purchase insurance, you pay premiums now in return for the right to submit a claim for compensation in the future.

market for loanable funds

a market in which savers supply funds to those who want to borrow

Standard deviation

a measure of how spread out a set of numbers are. This is the most commonly used measure of risk in financial markets. We can measure risk by looking at the standard deviation of an asset's return over time (which tells us how widely returns differ from period to period). Government bonds have smaller standard deviation than the stock market—but also remember that they have lower long-term average returns.

Aggregate price level

a measure of the average price level for GDP. Price indices, such as the CPI or GDP deflator, convert nominal values into real values.

dividend

a payment made periodically to all shareholders of a company. Payments are typically made annually or quarterly.

Mutual Fund

a portfolio of stocks and other assets managed by a professional who makes decisions on behalf of clients

Pension Fund

a professionally managed portfolio intended to provide income to retires

Expectations

about the future profitability of current investments adjusts the level of investment

closed economy

an economy that does not interact with other countries' economies. The identity between national savings and investment holds only in a closed economy.

Financial intermediaries

channel funds from people who have them to people who want them Banks lower transaction costs associated with sellers finding buyers and vice versa by acting as financial intermediaries, matching buyers with sellers. Stock exchanges facilitate trading between those that want to buy shares and those that want to sell them; the stock exchange decreases transaction costs by centralizing information about share prices and providing a marketplace for transactions.

National Savings

equal to private and public savings. Incorporating government spending and saving into the savings-investment identity yields: Investment = National Savings (NS) is equal to Y - C - G. National savings can be derived from Y = C + I + G + NX by setting NX = 0 (if a closed economy is desired), then moving C and G to the left-hand side: NS = Y - C - G. Thus, NS = I.

Market (systemic) risk

refers to risk that is broadly shared by the entire market or economy. Consider unexpected inflation. Some businesses will be more affected than others, but all businesses will face the consequences of the rising prices. This is difficult to eliminate with diversification.

Idiosyncratic risk

refers to risk that is unique to a particular company or asset. An example is the risk that a particular company makes a bad business decision, causing its own stock value to fall. This can be managed with diversification, such as buying stocks in many different companies (because it's unlikely that all will fall at the same time).

Monetary policy

refers to the actions made by the central bank to manage the money supply

Liquidity-preference model

refers to the idea that the quantity of money people want to hold is a function of the interest rate. This means the money demand curve slopes downward. The Fed sets the money supply, which means the money supply curve is set by monetary policy.

Reserves

refers to the money that banks keep on hand are either kept at the bank (in cash as deposits) or at the Federal Reserve. The amount of required reserves, the amount a bank is legally required to keep on hand, is set by the Fed.

Private savings

refers to the savings of individuals or corporations within a country Income = Consumption + Savings

financial system

represents the markets where financial products are traded It is a group of institutions that brings together savers, borrowers, investors, and insurers. It help people manage both money and risk.

Arbitrage

the process of taking advantage of market inefficiencies to earn a profit Some traders engage in arbitrage in an attempt to buy an asset in one market and sell it at a higher price in another market.

Money multiplier

the ratio of money created by the lending activities of the banking system to the money created by the central bank

Crowding out

the reduction in private borrowing caused by an increase in government borrowing. (is bad, more crowding out = more unemployment)

Money

the set of all assets that are regularly used to directly purchase goods and services

Contractionary monetary policy

when money supply is decreased to lower aggregate demand.